The Wrong Topic

The big topic in financial markets continues to be, when will the Fed hike the rate? We believe this meme is a feint, a diversion, an homage to a regime long gone and possibly not returning for years. Long time readers know that we consider "quantitative regimes" to be proper CB orientations in times of unacceptable inflation or disinflation (de). When metrics are moving around in acceptable parameters, a rates regime is proper calibration.

The transition back from Q to R can be a drawn out affair. Coming out of the Volcker Q-Regime, the Fed had (secretly then) begun the shift several years before Greenspan openly discussed targeting the Funds rate. An entire generation of traders had, in fact, never been exposed to the concept. Returning to a rates target is trickier from the other side of the spectrum, the side we are on now. The Fed balance sheet, and thus the balance sheets of the Fed's biggest constituents, is the issue.

Beyond a signaling device, why would the Fed raise the rate (what rate ?) while the system is loaded up with QE balance sheet accounting? More importantly, why would the Funds rate be the instrument chosen to send that signal? An IOER rate hike amounts to an increase in the "electronic marking up of balances" on Fed accounts. The FOMC and Staff are quick to warn, "Please don't call this a subsidy." Institutionalizing a spread, or soft floor, between IOER, Fed Effective and the RRF is an admission of uncertainty with regard to regime change.

We believe the balance sheet should be left to fall by default by a significant amount before anything beyond a symbolic small rate adjustment occurs. Stopping reinvestment is a critical first move. Time is the second. A CB wishing to return to a rates regime cannot simply ask market participants to ignore the nearly 3T elephant in the room. The post crisis regulatory changes are sweeping. The rates regime officials hope to return to is NOT the regime of the LIBOR based money system of the great credit cycle.

Here's a simple exercise. Look at the Fed's balance sheet. Look at the balance sheets of the biggest US and Euro banks. Now ask yourself, why are they talking about raising the rate?